Fed Eases Interest Rates in Effort to Gird U.S. Economy

Fearful that global financial chaos threatens the U.S. economy, the Federal Reserve Board cut its key interest rate by a quarter of a point Tuesday in a move meant to “cushion” America from a downturn outside its shores and growing financial weakness at home.

The Fed action dropped the federal funds rate, which banks charge each other for overnight loans, to 5.25%. The reduction should help the economy by keeping downward pressure on the rates consumers and businesses pay to borrow money.

While modest in size, the cut was viewed by many analysts as an extraordinary shift in course--and outlook--by the Fed that could be followed by further rate reductions amounting to a full percentage point or more in the next year.

Nonetheless, many investors were disappointed that the cut was not bigger. The stock market slumped immediately after the midday announcement but recovered most of the loss, with the Dow Jones industrial average finishing down 28.32 points at 8,080.52.

“What is most important about the Fed’s decision is that it shifts policy priorities to lowering rates and stimulating economic growth, rather than highlighting inflation,” said Jerry Jasinowski, president of the National Assn. of Manufacturers. “Rates should continue to be reduced as the global economy gets back on its feet.”

By officially lowering rates for the first time since January 1996, the Fed hopes to stimulate the U.S. economy by making credit easier to get, in the process helping America serve as a locomotive for weaker nations whose currencies and economies are under siege.

A healthy U.S. market ensures a continued appetite for foreign goods. In addition, lower U.S. rates might make foreign investors less inclined to yank capital out of their own struggling countries and shift it to the U.S. “safe haven.”

“Today is the first in a series of cuts,” said Bruce Steinberg, chief economist at Merrill Lynch & Co. in New York. He predicted that the federal funds rate, which stood at 5.5% before the cut, will be 4.5% or even lower by mid-1999.

He cautioned, however, that “nothing that the Fed does now will prevent a sharp slowdown worldwide and in the U.S. in 1999.”

Already, U.S. manufacturers have seen exports to pummeled overseas markets decline. A steady string of earnings announcements by major American firms in recent days has shown profits falling short of expectations.

But the size of the cut only underscored that policymakers are now struggling to balance the perils of financial instability around the world--and growing worries at home--with the reality that the national economy remains healthy by key measures, such as employment.

In one sign of these conflicting pressures, the Fed chose not to touch its highly symbolic discount rate, which is what banks pay to borrow directly from the Fed. That rate remains at 5%.

In a four-sentence statement, the Fed said it eased the federal funds rate “to cushion the effects on prospective economic growth in the United States of increasing weakness in foreign economies” and of tightening credit conditions domestically.

Federal Reserve officials have noted a developing squeeze on credit for some businesses, reflecting growing wariness on the part of lenders and investors to take risks in the current jittery global financial climate.

The rate cut “should now be consistent with keeping inflation low and sustaining economic growth going forward,” the Fed said in its statement.

Shortly after the announcement, two major U.S. banks, Norwest Corp. and U.S. Bancorp, reduced their prime lending rates to 8.25% from 8.5%. But most banks did not change their prime rates.

As recently as early August, the dominant view within the Fed was that the potential for higher inflation remained a greater danger to American consumers than any threat to the economy posed by foreign economic problems.

Since then, however, Russia’s chaotic devaluation of the ruble, deepening problems in Japan and intensifying pressures on Latin American currencies have further shaken the global financial system, undermining the U.S. stock market and, indirectly, eroding consumer confidence in this country.

There is a lag to rate cuts’ effect on the economy--often estimated at nine months--which makes their ultimate impact especially tricky to gauge. Some Fed watchers interpreted the central bank’s decision to leave the discount rate untouched as a signal that officials have not entirely dismissed their long-held fears of inflation, particularly given the tight U.S. labor market. The unemployment rate remains near a 28-year low, at 4.5%.

“Given the lingering fears of inflation, the logical compromise in my mind was a [quarter-point] move,” said Michael Moran, chief economist at Daiwa Securities in New York. “If the economy begins to slow down, they can do more in the future.”

Before Tuesday’s cut, the Fed had held the federal funds rate at 5.5% since March 1997.

Just Tuesday, there was new evidence that the dynamics of the U.S. economy could be changing under the battery of worrisome events overseas. U.S. consumer confidence fell in September for the third month in a row, according to the Conference Board, a New York-based research firm. The decline, which was sharper than analysts had expected, brought the confidence index to its lowest level since last October.

And in a dramatic example of today’s worldwide financial linkages--and the risks they pose--the Federal Reserve Bank of New York last week oversaw a private, $3.5-billion bailout of Long-Term Capital Management, a U.S. fund that had been hammered by misplaced bets on interest rates in the volatile global markets.

Against this backdrop, some of the reviews of Tuesday’s Fed action were lukewarm. “The rate cut was a small step in the right direction that appeared to be taken more for its psychological effect than for any real impact,” said Martin A. Regalia, U.S. Chamber of Commerce chief economist. “It remains to be seen if this move is enough to reassure jittery foreign markets and limit contagion effects in the global financial crisis.”

Indeed, the Fed’s cautious action, offered with no hint about future moves, left optimists and pessimists to wonder just how aggressive the central bank intends to be as the financial turmoil grinds on.

“They kind of leave us in suspense here,” said Paul L. Kasriel, chief U.S. economist at Northern Trust Co. in Chicago.

* IMPACT ON STATE: Rate cut could boost California’s housing and export sectors. D1

* MIXED MARKET: The Fed’s go-slow approach fails to inspire investors. D4